Credit Cycles, Expectations and Corporate Investment
New research by assistant professor of finance Candace Jens and her colleagues tackles an old theory. In 1957, economist Hyman Minsky posited that recessions were, in part, driven by firms overborrowing and overinvesting, which created not only their own subsequent fragility but that of the overall economy.
In an article forthcoming in the Review of Financial Studies, Jens and coauthors Huseyin Gulen, professor of finance at Purdue University; Mihai Ion, assistant professor of finance at the University of Arizona’s Eller College of Management; and Stefano Rossi, full professor of finance at Bocconi University, set out to test this theory empirically.
“One of the challenges in empirical testing is measurement,” Jens says. “So that was one of the big steps forward in this paper.”
The researchers looked at measures from reports written by equity analysts, whose job it is to evaluate firms and provide earnings forecasts for the next three to five years, and correlated them to firms borrowing and investing.
“We found that there were periods of time where you could predict, through time, the errors by equity analysts with their own errors, which means that systematically they were too excited about a firm’s prospects,” Jens explains. Three to five years down the line from such an event, the researchers saw a reversal, a rapid pullback in borrowing and investing – consistent with the cycles Minsky had described.
Comparing financially constrained firms with unconstrained firms – those that have easier access to external capital – the researchers found that both followed the same cycles. “This is important because it suggests that everybody – managers of and lenders to both sets of firms – is overexcited at the same time, regardless of credit market conditions,” Jens says.
Finally, the authors found that firms that borrowed and invested more at peaks saw greater reversals three years out, on average.
“These findings imply that the market is not self-regulating, the ship might not self-right,” Jens says. “Our paper suggests that if you’re going to consider Federal Reserve action, it may also be needed to tamp down investment and borrowing at the peaks if firms are overextending themselves and planting the seeds of fragility that then bring about a recession.”
Jens, C.E. (2024), Credit Cycles, Expectations, and Corporate Investment (with Gulen, H., Ion, M. and Rossi, S.) Review of Financial Studies.